Ever wondered how young companies are valued? Young/Private companies are not obligated to publicly disclose their financials, and obviously, there are no stock measures available for comparison to other similar companies. So, what is the valuation of young firms and how are they valued?
Introduction
Young company valuation is the set of methods used to assess a company’s current net worth. For public companies, this is pretty straightforward, i.e. we can simply fetch the company’s stock price and the number of shares outstanding or we can see their accounting statements from databases such as Money Control, etc.
Such a methodology, in any case, won't work with privately owned businesses, since data in regards to their stock worth isn't freely available, and since there's no stock listed on any stock exchange, it is difficult to determine the value of the company. Moreover, as young companies are not required to operate by the rigid accounting and reporting standards of SEBI that guide public firms, their financial statements may be atypical as compared to the public companies and might be difficult to interpret.
Why Value Young Companies?
Valuations are important for any business organization, be it young or public. It is important not just for the companies themselves, but also for the investors if the company wishes to go public someday. Investors can utilize these evaluations to help them determine the worth of potential investments. They can do this by using data and information disclosed by a company before going public.
Young Company Valuation Methods –
Although the information is usually harder to collect for young companies, it is still possible to calculate the values by using the information that is available for both the subject business and similar companies (both young/private and public).
Here, I will talk about the 2 common methods for valuing young companies, using data available to the public.
1. Comparable Company Analysis (CCA) –
The most common way to value a young company is to use Comparable Company Analysis. CAA method operates under the assumption that publicly traded companies under the same industry, that most closely resemble the young or the target firm has similar multiples (averages of the valuation).
In this method, we first ideally bracket down the target company’s characteristics like industry, size of the operation, growth rate, age, etc. Once an industry group is made, multiples can be calculated to see where the young company lies according to the industry standards/average. The company’s multiple can be calculated as follows:
The EBITDA is a company’s approximate representation of its free cash flow. The company’s enterprise value is the sum of its debt and market capitalization. The most common valuation multiples used in CCA are Enterprise Value to Sales (EV/S), Price to Earnings (P/E), Price to Book Value (P/B), and Price to Sales (P/S).
For example, let’s assume 6 companies of the same industry are to be valued as shown in the table below with their multiples.
From the above 2 tables, we find that the 6 companies have an average that can be compared.
EV/Sales has an average of 3.98, and companies C, E, and F are above it, whereas companies A, B, and D are below it.
EV/EBITDA has an average of 6.17, and companies C, D, and F are above it, whereas companies A, B, and E are below it.
P/E has an average of 6.01, and companies C, D, and F are above it, whereas companies A, B, and E are below it.
P/B has an average of 2.04 and companies D and F are above it, whereas companies A, B, C, and E are below it.
P/CF has an average of 3.68 and companies C, D, and F are above it, whereas companies A, B, and E are below it.
We have also calculated the minimum and the maximum values for each multiple to determine, which companies have the highest values, and which companies have the lowest values. Using these values, we can compare the values of the target company with the calculated standards of the industry.
2. Venture Capital Valuation (VCV) –
In Venture Valuation, we pursue a holistic evaluation approach. Although not every kind of valuation method is appropriate, Venture Capital Valuation assesses each company according to its industry and financing phase. The return on investment can be approximated by determining what return an investor expects from the specific level of risk attached to the investment.
In VCV, the earnings of the young firm are forecasted in a future year, when the company is expected to go public. These earnings, with a price-earnings multiple, are used to assess the value of the firm at the time of the IPO; this is called the exit or terminal value.
For example, let’s assume we are valuing InfoLine, a software company that is expected to have an IPO in the next 4 years, and the net income in 4 years is expected to be ₹5 million. If the price-earnings ratio of publicly traded software firms is 20, this would yield an estimated exit value of ₹100 million. This value is discounted back to the present at what venture capitalists call a target rate of return, given the risk that they are exposed to. This target rate of return is usually set at a higher level than the usual cost of equity for the firm. Using the software firm example again, if the venture capitalist requires a target return of 25% on his or her investment, the discounted terminal value for InfoLine would be ₹40.96 million.
In the end, we can conclude by saying that valuation, fundamentally, remains the same no matter what type of firm one is analyzing. In this article, I have laid out 2 methods that can be used to value such firms. The question is not whether these firms can be valued – they certainly can – but whether we are willing to live up with such estimates of value. To those who argue that these valuations are too complicated to be useful, my counter would be that much of this noise stems from real uncertainty about the future. As I see it, investors who attempt to measure and confront this uncertainty are better prepared for the volatility that comes with investing in these stocks.
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